Dallas Deceleration: Powell's Strategy and the Flattening Curve
Jerome Powell’s comments in Dallas yesterday suggest that the Federal Reserve is prepared to decelerate its interest rate cuts. The central message from his speech is that the Fed sees no immediate need for drastic action, with the economic resilience allowing it the flexibility to adopt a more measured approach. As Powell noted, “The strength we are currently seeing in the economy gives us the ability to approach our decisions carefully.”
However, the immediate focus is not just on the Fed’s strategy but on how the broader market is reacting. The yield curve has been steadily flattening in recent weeks, especially the spread between the 2-year and 30-year Treasury bonds. On 25 September, the 2-30 spread stood at 58 basis points, but by the close of trading yesterday, it had narrowed to just 26 basis points. This flattening signals growing concerns about future economic growth, with the market factoring in slower growth ahead, despite the Fed’s cautious optimism for the present.
The underlying dynamics are clear: shorter-dated bonds are being influenced by fears of near-term inflationary pressures, including rising tariffs and fiscal stimulus measures that may provide a temporary boost to demand. On the other hand, the long end of the curve reflects a more subdued outlook, with the market pricing in slower growth and lower inflation over the longer term. This divergence in sentiment between the short and long ends of the curve is a telling sign. It suggests that the market is increasingly wary about the future. This view aligns closely with our global growth model, which has been on a steady decline for several months. Tariffs are likely to exacerbate the slowdown in global growth, ironically hurting U.S. growth as well.
It now seems inevitable that we are heading into a period of slower global growth, unless there is a dramatic U-turn on tariffs, something from the Trump administration that seems exceedingly unlikely. With trade tensions escalating and the Fed perhaps slowing the pace of interest rate cuts, the likelihood of a return to a fully inverted yield curve is rising.
While recession risks have largely been priced out, due to the likely demand boost from Trump’s fiscal policies, an inverted yield curve remains one of the most reliable indicators of recession. If Powell maintains his cautious pace of rate cuts, the pressure on the short end of the curve will intensify, likely pushing the spread back into negative territory. A continued flattening, or even inversion, would signal that the market sees no swift path back to stronger growth, despite the Fed’s actions and Trump’s fiscal plans.
The great unknown remains the extent of the tariffs imposed and the response from other nations. While it is widely assumed that tariffs will harm China more than the U.S., a 2019 academic study of Trump’s 2018 tariffs by Amiti et al. found that nearly 100% of the tariff costs were passed onto U.S. consumers, with little effect on the prices received by foreign exporters. The tariffs led to significant price increases on imports, while the study also highlighted a shift in global trade patterns, as businesses sought alternative suppliers from abroad.
The flattening yield curve is therefore a signal that the market is adjusting to a reality where global trade risks, inflationary pressures, and slowing growth are emerging as more significant threats than previously anticipated. We are not merely witnessing a pause in rate cuts; we are seeing the market begin to price in a prolonged period of slow global growth, with the yield curve remaining a key indicator to watch for signs of further deterioration.
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